Tuesday, December 30, 2014

Since SAP announced to acquire Concur and eventually closed the acquisition for $8.3B many people have reached out to me asking whether SAP overpaid for Concur. I avoid writing about SAP on this blog even though I work for SAP because this is my personal blog. In this case, I decided to write this post because this is the largest enterprise SaaS acquisition ever and this question unpacks the entire business model of SaaS enterprise software companies.

If you’re looking for a simple “yes” or “no” to this question you should stop reading this post now. If not, read on.

People reaching out to me asking whether SAP overpaid for Concur in itself is a misleading question because different people tend to compare Concur with different companies and have a specific point of view on whether the 20% premium that SAP paid to acquire Concur is justified or not.

Just to illustrate financial diversity amongst SaaS companies, here are some numbers:

This is based on a combination of actual and projected numbers and I have further rounded them off. The objective is not to compare the numbers with precision but to highlight the financial diversity of these companies based on their performance and perceived potential.

Market cap is what the market thinks the company is worth. The market doesn’t necessarily have access to a ton of private information that the potential acquirer would have access to when they decide what premium to pay. While the market cap does reflect the growth potential it is reflected in a standalone pre-acquisition situation and not post-acquisition.

The purchase price, including the premium, is a function of three things: revenue, margins, and growth (current, planned, and potential). However, not all three things carry the same weight.

Revenue

For SaaS companies, annual recurring revenue (ARR) is perhaps the most important metric. It is not necessarily same as recognized revenue what you see on a P&L statement and ARR alone doesn’t tell you the whole story either. You need to dig deeper into deferred revenue (on the balance sheet and not on P&L), customer acquisition cost (CAC), churn, and lifetime value of a customer (LTV) that companies are not obligated to publicly report but there are workarounds to estimate these numbers based on other numbers.

Margin

If you’re a fast growing SaaS company the street will tolerate negative margins since you’re aggressively investing in for more future growth. Margin is less interesting to evaluate a fast growing SaaS company, for acquisition purposes or otherwise, because almost all the revenue is typically invested into future growth and for such SaaS companies the market rewards revenue and growth more than the margins.

Margin by itself may not be an important number, but the cost of sales certainly is an important metric to ensure there is no overall margin dilution post acquisition. Mix of margins could be a concern if you are mixing product lines that have different margins e.g. value versus volume.

Growth

Current and planned growth: This is what the stock market has already rewarded pre-acquisition and the acquirer assumes responsibility to meet and exceed the planned or projected growth numbers. In some cases there is a risk of planned growth being negatively impacted due to talent leaving the company, product cannibalization, customers moving to competitors (churn) etc.

Growth potential: This is where it gets most interesting. How much a company could grow post-acquisition is a much more difficult and speculative question as opposed to how much it is currently growing and planned to grow pre-acquisition (about 29% in case of Concur) as this number completely changes when the company gets acquired and assumes different sales force, customer base, and geographic markets. This is by far the biggest subjective and speculative number that an acquirer puts in to evaluate a company.

To unpack the “speculation” this is what would/should happen:

LTV

This number should go up since there are opportunities to cross-sell into the overall joint customer base. LTV does reduce if customers churn, but typically preventing churn is the first priority of an acquiring company and having broader portfolio helps strengthen existing customer relationship. Also, churn is based on the core function that the software serves and also on the stickiness of the software. The most likely scenario for such acquisitions is a negative churn when you count up-selling and expansion revenue (not necessarily all ARR).

CAC

This should ideally go down as larger salesforce gets access to existing customer base to sell more products and solutions into. The marketing expenses are also shared across the joint portfolio driving CAC down. This is one of the biggest advantages of a mature company acquiring a fast growing company with a great product-market fit.

Revenue growth

As LTV goes up and churn goes down overall ARR should significantly increase. Additional revenue generated in the short term through accelerated growth (more than the planned growth of the company pre-acquisition) typically breaks even in a few quarters justifying the premium. This is an investment that an acquiring company makes and is funded by debt. Financing an acquisition is a whole different topic and perhaps a blog post on that some other day.

Margin improvement

This is a key metric that many people overlook. Concur has -5.3% operating margin and SAP has promised 35% margin (on-prem + cloud) to the street by 2017. To achieve this number, the overall margins have to improve and an acquiring company will typically look at reducing the cost of sales by leveraging the broader salesforce and customer base.

This is a pure financial view. Of course there are strategic reasons to buy a company at premium such as to get an entry into a specific market segment, keep competitors out, and get access to talent pool, technology, and ecosystem.

Based on this, I’ll let you decide whether SAP overpaid for Concur or not.

Disclaimer:I work for SAP, but I was neither involved in any pre-acquisition activities of Concur nor have access to any insider Concur financial data and growth plans. In fact, I don’t even know anyone at Concur. This post is solely based on conventional wisdom and publicly available information that I have referenced it here. This post is essentially about “did x overpay for y?,” but adding SAP and Concur context makes it easy to understand the dynamics of SaaS enterprise software.